21 August 2010
people, plz try solving the following question and provide an explanation for ur answer; Raw materials inventory of a company includes certain material is on decline and replacement cost of the inventory at the year end is Rs.75 per kg. Is it possible to convert the material into finished product at conversion cost of Rs.125.Decide whether to make the product r not to make the product, if the selling price is (1)Rs.175 and (2)Rs.225.Also find out the value of inventory in each case.
21 August 2010
If the selling price is 175 : the net inflow is negative (175-75-125) and If the selling price is 225 the net inflow is 25 (225-75-125) Thus in the second option one should go for manufacture as There is recovery of Rs. 25 out of the Raw material cost. However, one has to keep in mind the composition of cost in terms of Fixed and Variable. In other words if the conversion cost represent major chunk of Fixed Overheads then one may go for further manufacture even if the selling Price is Rs. 175 so as to recover some of the Fixed Overhead contained in the conversion cost
21 August 2010
Example : Cost of raw material X Replacement Cost 75 Conversion cost 125 Total cost X + 200 At S.P. Rs 175 Loss = -X-25 Here even the cash cost of Rs. 75+ 125 has not been recovered At S.P. Rs. 225 Loss = -X + 25 Here Cash cost has been recovered and even the cost of RM is also recovered by rs. 25
21 August 2010
Example : Cost of raw material X Replacement Cost 75 Conversion cost 125 Total cost X + 200 At S.P. Rs 175 Loss = -X-25 Here even the cash cost of Rs. 75+ 125 has not been recovered At S.P. Rs. 225 Loss = -X + 25 Here Cash cost has been recovered and even the cost of RM is also recovered by rs. 25
21 August 2010
May be you are right Mr. ramesh but going through the question it seems that the Author wants to know whether one should make the product or not. I think the second part of the question pertains to the valuation of Inventory.
21 August 2010
thanks mr. pramod and mr.ramesh, however mr.ramesh do you mean to say that in case of selling price of rs.175 there is no profit element included?
21 August 2010
No In your query it has been told the selling price only. the selling price always include the profit element, but we cannot consider the total selling price becasue AS-2 clearly defining the net realiable value is the sale value less the cost incurring to realise that such sale, so sale vaule Rs.225, but for making such sale you need to incurr the coversion cost Rs.125, hence to relaisable value Rs.75
21 August 2010
so basically you are assuming that profit element is excluded and hence after deducting conversion cost from the sales value we attain the nrv of inventories.
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